Rick's Rants
or
A Just a Loonie with a Toonie.

October 04, 2006

Stock Options vs Restricted Shares

A number of people have asked me about this topic. Keep in mind that I am neither a lawyer or accountant. Get tax and legal advice as your situation is different than everybody else in the room.

Here is a simple, very high level definitions of both. Again, suspend the tax/bookkeeping issues for a minute, I know there are there and matter.

Options are the right to buy shares of stock at a particular price. If the stock price is $10 and you have an option to buy a share at $1, you have $9 dollars worth of value in that option. That is, of course, somebody is willing to buy the share itself for the 10 dollars. In a public, like Microsoft or IBM, it is not a problem but in a private company, these values (the $10 price) can be a bit, shall we say, loose. In any event, that is how an option works. It is exactly as the word says, an option to buy a share at a particular price.

Options get value resulting from the difference between the strike price and the options price. My example above shows $9 of value for each option. The value of the options will vary on as the price of the shares moves up or down.

A restricted share is a share of stock in the company that typically is yours but with some restrictions which go away over time. You might have a 10 shares of restricted stock where every year 2 shares become free of the restrictions. That period of time where restrictions go away is called the vesting period. The restrictions could be right of sale, the requirement to sell back to the company, voting rights, etc. The big point is the share has value like any other share in the company. So, like the above example, a $10 stock price means a restricted share of stock will be worth $10.

That's exceedingly simplistic but you get the basic idea.

In the case of 100 restricted shares and 100 options in the same company with a stock price of $10 per share, you'd naturally ask what is better.

First, if you have penny options then for all intent and purposes, the options and the restricted shares are the same. An option at a penny strike price and a restricted share of a ten dollar stock means the option is worth $9.99 so it is the same.

I like restricted shares for the optics reason above all else.

Please suspend the tax issues, the issues of this or that on the company books or other issues which, yes, are important. Let's just talk optics.

Most people out there in the world do not get stock options. I've seen stats about the number of companies that offer stock options, stock purchase plans, etc, and outside the technology world, it is a very low number. Lots of people's eyes glaze over when you talk about options. So, to me, simple is good. Everybody on the same side of the table is good. Easy math for everybody is good.

If a company has a share value of $10 and I give you 1000 restricted shares you have $10,000 of immediate value in your hands. It's simple, price times what you get. It is a clear optic of value to somebody. If I give you 1000 options, stock price starts at $10 and strike price is $10, you have $0 of immediate value. If I give you a strike price of $5 which is a 50% discount of the price of the stock (private company, ignore the rules for this exercise), you still have only $5000 of immediate value. As I mentioned before, unless the option strike price is a penny, there is a dramatic difference in immediate value, all depending on the strike price.

In a small start up, call me simple, there is just something straight up about being able to give people restricted shares and talk about the price of those shares, adding value, what happens if the company takes more money, what fully diluted means, etc. I believe that even if you have a down round and dilution happens, the shares are worth something. Yes, you can top up option plans, re-price, etc.

There are significant/meaningful tax issues, totally. While there are some interesting ways around it, get advice and for sure round up other opinions.

Lots of VCs have opinions on this and I'm admitting that for me this is an optics based, simplistic view. I like saying here is your piece. I like people understanding value, no mental math, no spreadsheets of scrolling in the money/out of the money scenarios, etc.

I also know I am in the minority view on this for lots of valid reasons but folks asked and we aim to please.

Comments

Normally, simple is better; however, I think that you can not ignore the tax implications in this case. The "tax optics" (at least in the U.S.) favor options. This is due to the fact that restricted stock is taxed as compensation once the restrictions disappear. Options, on the other hand, have no tax consequences until they are exercised. Making employees pay taxes on private stock is dangerous since, as you say, the value of private stock is rather loose. The fact that an employee might pay taxes on private stock that could turn out to be worthless if the start-up fails is not a good situation. With options, on the other hand, the employee can avoid taxes until the options have some definite value (such as when a liquidity event like an IPO or merger occurs).

The one thing I never heard with all the expensing of options hullabaloo is how companies are supposed to value them. What impact do cliffs and vesting have on a Black/Scholes valuation? Are there agreed upon formulas for valuing vesting options?

In an early stage startup, if you're handing out equity as compensation, you should at the very least not be asking your people to chip in out of their own pocket (or, more accurately, their families' pockets, since they're not going to have any cash) to the IRS for it.

Yes, blame the IRS for counting as "income" something like restricted shares in a private company, that you can't possibly convert into rent and food. But in lieu of changing the law (which would be tough, since politicians and most voters confuse the possibility of getting rich in the future with the fact of actually being rich today) I count it as immoral to load employees down with extra tax obligations before you're able to pay them real money, and call it "compensation".

Q: What impact do cliffs and vesting have on a Black/Scholes valuation?

A: Intuitively, they should decrease the valuation because every restriction makes the options less valuable to the holder. One simple way to model a vesting option under Black/Scholes is to replace the option grant date with the date of vesting. This would effectively shrink the lifespan of the option and thereby make it less valuable.

Q: Are there agreed upon formulas for valuing vesting options?

A: I don't think so. Anyway, Black/Scholes option pricing models make more sense when there is a public market for the stock underlying the option. In a private company, option pricing is more of an art form.

It is my understanding one way around the tax issues with restricted shares is to offer Restricted Vesting UNITS of later to be created shares. This is how Microsoft does it... and you know they get great tax advice!

As for being a straight shooter from the start "optics"... I'm with Rick on this one. Vesting restricted shares are dare I say intuitive!

BTW: Hello Rick & Toronto Venture Folks - I just moved up here and am excited about contributing to the community.

I'm in a management position. Many months ago I was given 5400 units (whatever that means) for $60,000.
I didn't have the $60,000 so a third party stepped in who was not part of the company. He then has charged me $435 per week interest on the loan. Last week the company merged with another already publicly traded company who's stock is around 9 cents per share since the merger. Up only about a penny. My questions are: What do these units now mean to me? What is a private sale? How do I take care of this $60,000 loan since I'm broke? HELP!